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Chris Gilchrist: Explaining client risk should be simple


The purveyors of attitude to risk questionnaires have made a nice living out of persuading financial advisers that by using such a questionnaire they give better advice and reduce the risk of complaints. I have always been sceptical about this, for two main reasons:

  • The FCA does not require advisers to measure the client’s attitude to risk but it does require them to assess the client’s capacity for loss.
  • The only way of aligning the output from an ATR questionnaire with investment portfolios is through capacity for loss, which is not aligned with attitudes and requires independent assessment by an adviser.

My firm uses capacity as the primary way of creating risk profiles. After all, what the client (not to mention the OED) means by risk is not volatility but the chance of a permanent loss of capital or income, best measured by historical peak-to-trough declines.

I am delighted to see common sense confirmed in a piece of research for the Pension Institute by two professors, including David Blake (professor of pensions economics at Cass Business School), who has also written on behavioural finance.

The key finding from their research is: “Taken in isolation, a saver’s attitude to risk score is not a good guide to the amount of savings risk a saver is able and willing to take.”

This is because their survey shows there is no relationship between attitude to investment risk and the amount of savings risk (the risk of a shortfall from stated future income goals) people are able and willing to take.

Experienced advisers will know that this statement is true. It reflects a set of behavioural inconsistencies or biases which have been identified by behavioural economics over the past 20 years. People save too little because the present is ‘available’ in the way the future is not, and because they project  the kind of conservatism that is appropriate for emergency funds or short-term needs into longer-term goals in the phenomenon referred to as reckless conservatism. Mental accounting – being prepared to adopt different risk-return profiles for different goals – also erodes the usefulness of ATR questionnaires.

This leads Professor Blake to the conclusion that many of those surveyed for his research were prepared to take on far less risk than they should in order to stand a chance of meeting their savings goals. 

And he says advisers and regulators ought to nudge people into accepting more risk with their savings rather than reducing ambitions or working for many more years.

My one hope is that this research is read carefully by people at the FCA and the FOS. Partly thanks to their regulations and interpretations of regulations, there has also been an institutional failure to accept the implications of known behavioural biases. As regards their savings for long-term goals, most people without professional financial advice tend to take far too little risk.

A good start for advisers is a non-psychometric questionnaire that elicits responses about not just attitudes but goals, experience, knowledge and capacity for loss. Better still if the questionnaire output leads to a provisional assessment that is adapted as a result of the adviser’s assessment of capacity.

The adviser’s role is simple: tell the client how much risk they need to take to achieve their goals and how much risk they can afford to take.

Then negotiate.

Chris Gilchrist is director of Fiveways Financial Planning, a contributing author to Taxbriefs Advantage and edits The IRS Report



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There are 11 comments at the moment, we would love to hear your opinion too.

  1. “My one hope is that this research is read carefully by people at the FCA and the FOS. Partly thanks to their regulations and interpretations of regulations, there has also been an institutional failure to accept the implications of known behavioral biases.”

    Chris, I suggest you go back and re-read FG11/5. It was the then FSA which highlighted the need to concentrate on capacity-for-loss and negotiate the difference between the risk preferred and the risk required – not your johnny-come-lately professors.

    The impact of that guidance has been masked by the noise over RDR etc. But 3 years later I see remarkable movement on this front (at least in the financial planning space). Industry-wide the change is slow but sure and is now gaining momentum. In my view 20 years time we will look back and see FG11/5 as being more important for consumers than RDR.

  2. Whilst FG11/5, written in 2011, kind of kick-started the whole debate around understanding and assessing risk, the issue definately (thankfully!) hasn’t gone away.

    The launch of the FCA not only created a new regime, a new culture, but created a renewed focus on suitable outcomes for the consumer. This includes using “Johnny-come-lately” Professors and other academics to ensure they are including the LATEST thinking.

    This thinking has already worked its way into COBS9, the engine room of conduct risk regulation in the UK, which shows ATR questionnaires and recording of client risk appetites being part of the FCA’s attempts at getting suitability right.

    One thing is clear – the current method of getting a ‘risk number’ or ‘risk description’ does not answer the most important questions from a regulatory perspective. Is it suitable and is the consumer capable of making an informed decision?

    Our continued research, led by one of the world’s leading authorities in Risk Based Decision Making, supports the fact that there are far too many factors involved in assessing a persons risk, meaning that you simply can’t use a tool that tells the consumer they are “7 out of 10” or that they are “medium risk” and expect a suitable outcome. It also shows that are better ways to understand the risk personality of a consumer, and I think as an industry we should be open-minded and explore these solutions.

    However, the most important thing here is this. Assessing risk is only one element. There are other factors that must be considered in order for us to ensure that we deliver suitable solutions to suitable consumers. But that’s a discussion for another day !

  3. As noted by Tim Page, in light of FG11/5 this article is out of date. In the guidance the FSA clearly addressed the issues and helpfully broke them down into three fundamental point, some of which, to be fair, Chris has covered fully.

    My original reading of the guidance, and current understanding, is that risk can be seen as a three legged stool comprising:

    Risk tolerance – the natural tolerance a client has to events affecting their finances. Moving outside this band is likely to make the client uncomfortable or even distressed in adverse conditions

    Capacity for loss – the ability of the client to withstand a temporary or permanent loss of income or capital

    Risk required – how much risk they need to take to have a realistic chance of achieving a target

    It is inevitable that these three will rarely match up and this is when a discussion (negotiation???) about what is most important ensues and the client accepts and agrees a position within the risk triangle. The adviser then recommends accordingly.

    Ignoring one of these factors or pushing the client in a direction they don’t want to go is not going to end in a happy place. By all means sell to a need but watch out if the client doesn’t get what they want.

    Last point. Being disparaging of people who are offering a service and making a living out of it is poor journalism. Taking the first few paragraphs, changing it to refer to ‘purveyors of financial advice’ and ‘clients’ and adding a few reasons why you don’t need the former would be just as poor.

  4. goodness gracious 14th March 2014 at 1:40 pm

    Thank you Chris, this article expresses my view of over elaborate risk profiling tools that mainly come up with the wrong answer. Capacity for loss is high, clients should be encouraged to take a more adventurous investment unless a lower risk can achieve their goals (if any) Clients with low capacity for loss are more problematical, should they be investing at all? Will the risk premium make any difference to their plans. Then go from there, but keep them informed.
    Every rep I see seem to concentrate on lower risk, multi managed or similar funds, using Distribution Tech’s risk numbers. Are they now very popular, it looks like it!
    I get very few lower risk clients, but talk risk-reward and loss capacity through in depth. This is the same with my colleagues, so how many just accept a risk profiling tool’s numbers, match a portfolio and think they have got it cracked? You might as well buy through a machine, and this is not the job of an adviser.
    Perhaps it is a result of large number of firms using a network where a ‘keep it simple stupid’ investment attitude is thought to be compliant and cut down complaints together with delivering consistent standards and TCF. Trouble is you are not necessarily providing advice in the clients interests, more to satisfy the regulator and your firms interests. Talk to clients, do not rely on computer programmes.

  5. @ goodness gracious

    “I get very few lower risk clients”

    Now why is that? Assuming you have a reasonable number of clients their spread of risk would follow a normal population distribution curve between low and high. If it doesn’t what’s the reason? Source of clients, undue influence, not asking the right questions…

  6. goodness gracious 14th March 2014 at 3:42 pm

    Grey area.
    I get very few low risk clients because often their capacity is not sufficient to invest money. If clients have capacity and wish an outcome that justifies risk investments to get a better return, I will discuss the investment risk in great depth. If they can’t accept the risk level to get that return, why do they want to invest at all? As Professor Blake states : many of those surveyed for his research were prepared to take on far less risk than they should in order to stand a chance of meeting their savings goals.
    It’s discussion with clients, looking at worst case scenarios as well as best case, to allow them to make up their mind and convince them about the level of risk they need to take to achieve what they need to.
    Are global bond funds riskier than global equities? Is risk volatility? Some investments are shorter term, invest, then take profit quickly and go somewhere else, others are longer term. Does this effect risk? How long do I invest in Japan at the moment? Are US large cap overvalued? Will capital values of Gilts come back to pre 2008 levels? I don’t know for sure, but I do know what works and what doesn’t.

  7. A man went to see his doctor complaining of chest pains. The doctor asked him a number of questions in order to establish his attitude to health. The results of the questionnaire showed that the patient preferred to have indigestion rather than a heart attack.

    ATR is ONLY of importance once risk capacity has been established. sometimes capacity is such that higher levels of investment risk have to be taken if client objectives have any chance of being met.
    Capacity is NOT just what the client afford to lose. Quite frankly I could care less what a client thinks. He has come for advice not to be sold what he wants.

  8. I think we need to be a little careful thinking of capacity for loss in absolute terms.

    For example, three years ago I went out for the day. On the way home I had an accident. Obviously it wasn’t fatal or I would not be writing this but it could easily have been. That would have been a 100% loss, totally irrecoverable. I do not have the capacity for the loss of my life.

    On the other hand, was it imprudent? I could have stayed at home in front of the TV. I wouldn’t have had a car accident but home is a dangerous place too – and if you want to avoid any risk never go to bed because most people die there.

    So the mere fact that one cannot afford possible loss does not automatically mean it should not be taken.

  9. @ Bones

    Very poor analogy if I might say so. Firstly a doctor will ask about symptoms and provide a diagnosis (This is where you are right now) that is not dependent on anything the patient thinks.

    THEN they will discuss the possible remedies. That might include ones that are less effective but have fewer side effects or another that can be much more effective but has potentially bad side effects. Based on yours and good gracious’ method they get the latter because you know what’s good for them.

    It’s a method but not one I would like to defend with the FOS or the regulator.

  10. @ Grey Area – Doctors do ask about symptoms. Too many IFAs seek only to determine ATR – this is NOT the same as trying to determine where you are right now but rather pays far too much attention to how the client feels.

    How a client feels should only come into play when risk capacity has narrowed down the choice to several competing possible solutions.

    As to the “you know what’s good for them” well had better or you are not an adviser but rather a supplier of whatever the client wants. You may be wrong in what you think is good for them but an adviser is paid to give advice not to just pander to the whims of the client.

  11. @ Bones

    Perhaps we are talking at cross purposes a little here. All I’m saying is that risk tolerance is a factor, along with capacity for loss and risk required (to meet objectives). Any one of which may be the more important factor – that needs to be discussed and agreed with the client not dictated by the adviser.

    There is no question of pandering to the wants or whims of the client. However, a reading of the rules on suitability makes clear that advice involves giving the client the ability to make an informed decision. It is not the adviser making the decision for the client.

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